BTBE1033 / BTEM1093 PRINCIPLES OF ECONOMICS

TOPIC 3: MARKET THEORY: ELASTICITIES OF DEMAND AND SUPPLY

PRICE ELASTICITY OF DEMAND

 The concept to measure the responsiveness or sensitivity of consumers to a change in the price of a
product.
 The Price Elasticity of Demand, with coefficient (Ed)

% change∈quantity demanded of product x

Ed=
% change∈ price of product x

 Ed < 1: demand of product is inelastic

 Ed > 1: demand of product is elastic
 Ed = 1: demand is unit elastic

 Refined Midpoint Formula:

change∈quantity demanded change∈ price

Ed= /
∑ of quantities /2 ∑ of prices/2

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 Examples:

Elasticity Coefficient (Ed) Interpretations of Ed

Price/ Ticket
Qd
(RM)

1 8 RM8 to RM7: RM7 to RM8: Elastic

Ed1 = (2-1)/(3/2) ÷ (7- Ed2= (1-2)/(3/2) ÷ (8-
8)/(15/2) = 5 7)/(15/2) = 5
2 7

RM7 to RM6: RM6 to RM7:

Ed = Ed =
3 6

RM6 to RM5: RM5 to RM6:

Ed = Ed =
4 5

RM5 to RM4: RM4 to RM5:

Ed = Ed =
5 4

RM4 to RM3: RM3 to RM4:

Ed = Ed = 0.64
6 3

RM3 to RM2: RM2 to RM3:

Ed = Ed =
7 2

RM2 to RM1: RM1 to RM2:

Ed = Ed =
8 1

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Interpretations of Ed

Elastic Demand
 Demand is elastic if a specific % change in price results in a larger % change in quantity demanded.

% ∆ in quantity demanded
P is larger than
% ∆ in price
P1
P2
D

Q
Q1 Q2

Inelastic Demand
 Demand is inelastic if a specific % change in price produces a smaller % change in quantity demanded.

% ∆ in quantity demanded
P is smaller than
% ∆ in price
P1

P2
D
Q
Q1 Q2

Unit Elasticity
 Demand is unit elastic if a % change in price and the resulting percentage change in quantity demanded
are the same.
% ∆ in quantity demanded
P is equal to
P1 % ∆ in price

P2

D
Q
Q1 Q2
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Extreme Cases

Ed = 0; demand is perfectly inelastic

Ed = ∞; demand is perfectly elastic

 Demand is perfectly inelastic

 The price change results in no change whatsoever in quantity demanded.
 A line parallel to the vertical axis such as D 1in the figure below shows perfectly inelastic demand
graphically.

P D1

Perfectly inelastic
demand
Ed = 0

 Demand is perfectly elastic

 A small price reduction would cause buyers to increase their purchase from zero to all they can
obtain.
 The elasticity coefficient is infinite ( = ∞). A line parallel to the horizontal axis such as D 2in the
figure below shows perfectly elastic demand graphically.

Perfectly elastic
demand
Ed = ∞

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Determinants of Price Elasticity of Demand

Substitutability
 The larger the number of goods substitute products available, the greater the elasticity of demand.
 The best example can be obtained from purely competitive market where there are many perfect
substitutes for the product or any given seller.
 The demand to that single seller will be perfectly elastic.

Proportion of Income
 The higher the price of a good relative to consumers’ incomes, the greater will be the elasticity of demand
for it.
 Increase in the price of low-priced product means an small fraction of additional expenditure relative to
one’s income, quantity demanded will probably decline only slightly (slightly inelastic). On the other hand,
increase in the price of higher-price product means additional of significant expenditures to one’s income,
quantity demanded will likely diminish significantly (high price elasticities).

Luxuries Versus Necessities

 The demand for necessities tends to be inelastic. In contrast the demand for luxuries is elastic.
 An increase in price will not reduce significantly the amount demanded for necessities product but the
quantity demanded of luxuries will be reduced in larger amount.

Time
 The larger the time period under consideration, the product demanded is more elastic.
 Consumer will take time to create new hobbies or develop a taste to substitute.
 When the price of a product rise, it takes time to find and experiment with other products to see if they are
acceptable.

The Total Revenue Test

 The importance of elasticity for firms relates to the effect of price changes on total revenue and thus on
profits (total revenue minus total costs).
 Total revenue (TR) is the total amount the seller receives from the sale of a product in a particular time
period.

TR=P x Q

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P = product price
Q = quantity demanded and sold
 Elastic demand: Price ↑ TR ↓; Price ↓ TR ↑
 Inelastic demand: Price ↑ TR ↑; Price ↓ TR ↓

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Demand curve

P Elastic
(RM) 8 Ed > 1

6 Unit elastic
Ed = 1
5

4
Inelastic
3 Ed < 1

1
Qd
1 2 3 4 5 6 7 8

When
P ↓ / ↑TR unchanged
When When
TR
P ↓TR ↑ P ↓TR ↓
@ RM 5 = 5 x 4 = 20
TR TR
@ RM 4 = 4 x 5 = 20
@ RM 8 = 8 x 1 = 8 @ RM 4 = 4 x 5 = 20
@ RM 7 = 7 x 2 = 14 @ RM 3 = 3 x 6 = 18
@ RM 6 = 6 x 3 = 18 Demand is unit elastic @ RM 2 = 2 x 7 = 14
@ RM 5 = 5 x 4 = 20 @ RM 1 = 1 x 8 = 8

Demand is elastic Demand is inelastic

TR

20

18

16

14

12

10

6 TR

2
Qd
1 2 3 4 5 6 7 8
Total revenue curve

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Cross and Income Elasticity of Demand

 Price elasticities measure the responsiveness of quantity of a product demanded or supplied when its
price changes.
 Besides price of the product, the consumption of a good is also affected by a change in the price of a
related product or by a change in income.

Cross Elasticity of Demand

 Measures how sensitive consumer purchases of one product (X) are to change in the price of some other
product (Y).
 Coefficient of cross elasticity of demand (E xy)

percentage change ∈quantity demanded for product X

E xy =
percentage change∈ price of product Y

 Exy> 0
 If cross elasticity is positive, meaning increase in price of product Y will increase sales of product X,
vice versa, then X and Y are substitute goods.
 Example: Increase in price of Kodak film causes consumers to buy more Fuji film.
 The quantity demanded or sales of X move in the same direction as a change in price of Y.
 The larger the positive Exy, the greater is the substitutability between the two goods.

 Exy< 0
 If cross elasticity is negative, meaning increase in price of product Y will decrease sales of product Y,
vice versa, then X and Y are complementary goods.
 Example: Increase in price of camera will decrease the amount of film purchased.
 An increase in the price of Y decreases the demand for X.
 The larger the negative Exy, the greater is the complementarity between the two goods.

 Exy ≈ 0
 A zero or near zero cross elasticity suggests that two products being considered are unrelated or
independent goods.
 Example: walnuts and film.

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Income Elasticity of Demand

 Measures the degree to which consumers respond to a change in their incomes by buying more or less of
a particular good.
 Coefficient of income elasticity of demand (E i)

percentage change∈quantity demanded

Ei =
percentage change∈income

 Ei> 0
 Normal or superior goods.
 Quantity demanded for good increases as income increases, vice versa.
 For most goods, the Ei is positive. But value of Ei varies greatly among normal goods.
 For example: Ei for automobiles is about +3, Ei for farm products is about +0.2.

 Ei< 0
 Inferior goods.
 Quantity demanded for good decreases as income increases, vice versa.
 Examples: retread tires, used clothing, muscatel wines.

PRICE ELASTICITY OF SUPPLY

 Elasticity of supply measures the responsiveness of the quantity supplied to changes in the price of goods
or services.
 The Price Elasticity of Supply, with coefficient (Es)

% change ∈quantity supplied of product x

Es=
% change ∈ price of product x

 The refined Price Elasticity Supply, with coefficient (Es)

change∈quantity supplied change∈ price

Ed= /
∑ of quantities/2 ∑ of prices/2

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Interpretations of Es

Elastic Supply
 Es> 1, supply is elastic.
 Producers are relatively responsive to price changes.

P
S
P2
P1

Qs
Q1 Q2

Inelastic Supply
 Es< 1, supply is inelastic.
 Producers are relatively insensitive to price changes.

P S

P2
P1

Qs
Q1 Q2

Unit Elasticity of Supply

 Es = 1, supply is unit elastic.

P S
P2

P1

Qs
Q1 Q2

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Perfectly Inelastic of Supply

 Es = 0, supply is perfectly inelastic.

P
S

Qs

Perfectly Elastic
 Es = ∞, supply is perfectly elastic.

Qs

Price Elasticity of Supply: Immediate Market Period, The Short Run and The Long Run
 The degree of price elasticity of supply depends on how easily and therefore quickly producers can shift
resources between alternative uses.
 The easier and more rapidly producers can shift resources between alternative uses, the greater the price
elasticity.
 Shifting resources takes time. Therefore time is the major determinant to the price elasticity of supply.
Longer time allows producers to adjust their production of goods in response to price change, therefore
greater elasticity of supply.
 Impact of time on elasticity is analysed by distinguishing the immediate market period, the short run and
the long run.

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Market period
 The market period is the period that occurs when the time immediately after a change in market price too
short for producers to respond with a change in quantity supplied.
 Most of the supply curves for products during the immediate market period are perfectly inelastic (vertical
or parallel to Y-axis). Example: Farmer brings a truckload of tomatoes, which is the entire season’s output,
to market for sell. If the price is higher than anticipated, the farmer will not be able to increase the supplied
quantity immediately as tomatoes do not grow overnight. Even if the price is lower than anticipated,
farmers will still sell the entire truckload to avoid losses through spoilage. In this case, supply is perfectly
inelastic as buyers will get the fixed quantity supplied; it elicits no increase in output. Therefore the market
period may be a full growing season.
 However, for not perishable goods, when prices rise, producers may choose to increase quantity supplied
by drawing down inventories of unsold, stored goods. For producers of goods that can be inexpensively
stored, there may be no market period at all.

P S

P2
P1
D2
D1
Qs
Q1

Immediate market period

The Short Run

 The short run is a period of time too short to change plant capacity but long enough to use fixed plant
more or less intensively to alter output, supply is therefore more elastic.

P S

P2
P1
D2
D1
Qs
Q1 Q2

The short run

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The Long Run

 The long run is a time period long enough for firms to adjust their plant capacity and for new firms to enter
(or existing firms to leave) the industry, therefore supply becomes still more elastic.

S
P2
P1
D2
D1
Qs
Q1 Q2

The long run

Applications: “Government Controlled Prices”

 Price Floors and Price Ceilings are price controls, examples of government intervention in the free market
which changes the market equilibrium. They each have reasons for using them, but there are large
efficiency losses with both of them (Experimental Economics Centre, 2005).

Price Ceilings and Shortages

 A price ceiling is the government-imposed maximum legal price a seller may charge for a product and
services.
 Rationale of having price ceiling is to enable consumers to obtain some essential goods or services that
they could not afford at the equilibrium price.
 In Malaysia, government imposed on essential goods such as rice, chicken, sugar, steel bar, steel billet,
cement, low cost houses. Government also impose price ceiling either on all products or on a very wide
range of product to restrain inflation.
 Price ceiling induce shortage of goods.

Price ceiling in the market for maple syrup

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Price Floor and Surplus

 Price floor is the government-imposed minimum price a seller may charge for a product and services.
 A price above is legal, a price below is illegal.
 Rationale of having price floor is that some commodities and services are being sold in an unfair market
with too low of a price and thus their producers deserve some assistance.
 An example is the price floor of the cigarettes set by the Malaysian government to ensure that the tobacco
sector still can earn their share of income to ensure their survival.
 Price floor also imposed on foreign buyers in acquisition of local residential property.
 Price ceiling may induce surplus in the market due to excessive goods supplied than the consumers
willing to buy or consume.
 Government may purchase the surplus output.

Price floor in the market for non-fat dairy milk

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